BASIC CONCEPTS FOR DEFERRED TAXES
All the companies generate revenues from their own economic activities. All the generated revenues are shared among stakeholders. Lenders get share of the revenue in the form of interest, owners get share of the revenue in the form of dividend and similarly, Government get share of the revenue in the form of taxes.
Taxes are calculated by applying the tax rates to the profit amount. Taxes rates are determined and prescribed by income tax law of the respective country and, profit amount shall have to be determined and calculated as per the INCOME TAX ACT of the respective country.
The profit calculated as per books of accounts are irrelevant for calculation of the tax amount.
But the question is ‘what is deferred taxes????’
Let me explain the concept by following illustrations:
EXAMPLE 1
Particulars As per books of accounts As per income tax law
Profit amount 100000 200000
Tax rate 20% 20%
Tax amount 20000 40000
Excess tax paid RS 20000
EXAMPLE 2
Particulars As per books of accounts As per income tax law
Profit amount 200000 100000
Tax rate 20% 20%
Tax amount 40000 20000
Less tax paid Rs. 20000
Above Scenario arises because of excess Tax payment or less Tax payment. These situations occur due to temporary differences or timing differences. These situations are mentioned below:
When more taxes are paid in the current period then we shall have to pay less tax in future period. In this situation, deferred tax liability shall have to be recognized.
When less tax is paid in the current period then we shall have to pay more taxes in future period. In this situation deferred tax asset shall have to be recognized.
Temporary differences mean the difference between the tax base and the carrying amount of an asset or liability.
NOTE:
While recognizing deferred tax asset, there shall be reasonable certainty of earning sufficient future taxable income in future period.
Also, we shall have to be prudent while recognizing deferred tax asset.
Earning sufficient future taxable income implies that there shall be documentary evidence of earning sufficient future taxable income in the future period
And, against such future taxable income deferred tax asset are adjusted.
Deferred tax asset are created because of following items:
1.Unabsorbed depreciation
2.Carry forward tax losses
Deferred tax asset and liability are recognized by following approach:
1. Profit and loss account approach
2. Balance sheet approach
NOTE:
NFRS and IFRS provide validity to the balance sheet approach but profit and loss account approach is not valid for recognition purpose.
Balance sheet approach is explained by following illustrations:
EXAMPLE 1
Particulars As per books of accounts As per income tax law
Cost of an asset 100 100
Depreciation 50 60
WDV value 50 40
Decrease in benefits by RS 10 leads to decrease in income which ultimately leads to increase in liability. In this situation, deferred tax liability shall have to be recognized.
EXAMPLE 2
Particulars As per books of accounts As per income tax law
Cost of an asset 100 100
Depreciation 60 50
WDV 40 50
Increase in benefits by RS 10 leads to increase in income which ultimately leads to increase in asset. In this situation, deferred tax asset shall have to be recognized.
NOTE:
Total tax shown in profit and loss account = Current tax ± deferred taxes
Current tax is the tax calculated as per income tax law.
Deferred tax is either deferred tax expense or deferred tax income.
Entries:( presentation in financial statements)
For deferred tax liability For deferred tax asset
1. Deferred tax expense a/c ...DR 1. Deferred tax asset a/c ….DR
To, deferred tax liability a/c To, Deferred tax income a/c
2. P/L a/c ….. DR 2. Deferred tax income a/c.. DR
To, Deferred tax expense a/c To, P/L a/c
